Agricultural Finance - Texas A&M University



AGEC 432 – Real Estate and Finance: Part I

Practice Problem Set #4

1. Assume you are considering investing in the following project. The economic life of the project is three years.

Year 1 Year 2 Year 3

Expected net cash flow 15,000 16,000 17,000

Coefficient of variation 0.10 0.11 0.14

Risk free rate of return 0.05 0.06 0.07

Slope of risk/return curve 0.20 0.23 0.25

Shift coefficient for leverage 0.05 0.06 0.07

Total assets 200,000 225,000 240,000

Total equity 120,000 110,000 100,000

If the net capital outlay for this project is $40,000, no additional working capital is needed, and the market value of assets required under this project is $5,000 at the end of the third year, would you make the investment? Why?

2. Suppose you are considering expanding the size of your business. You are earning an annual rate of return of 10 percent on your existing assets with a standard deviation of 2 percent. The new investment would represent 10 percent of the expanded operation while the existing assets would represent 90 percent.

a. If you expect to earn a rate of return of 11 percent on the new project with a standard deviation of 3 percent and the correlation coefficient between the returns from the firm’s existing assets and the new project is 0.85, would you adjust the required rate of return calculated for the new project alone. Is so, why and how much? If not, why not?

b. If the correlation coefficient were instead –0.95, would you adjust the required rate of return calculated for the new project alone? Is so, why and how much? If not, why not?

3. Assume a firm produces two products (donuts and bread). Assume further that the firm has three activities (mixing, baking and shipping). Consider the following information on the firm’s overhead:

Driver

Overhead Activity Donuts Bread

Mixing $30,000 30,000 10,000 20,000

Baking $10,000 10,000 2,500 7,500

Shipping $20,000 20,000 10,000 10,000

If the firm bakes 100,000 boxes of donuts and 200,000 loaves of bread, please determine the overhead per box of donuts and per loaf of bread using activity based cost (ABC) accounting.

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